What is an exchange-traded fund?
An exchange-traded fund (ETF) is an investment company with shares that trade intraday on stock exchanges at market-determined prices. Investors may buy or sell shares of an ETF through a broker or in a brokerage account, just as they would the shares of any publicly traded company. There are a number of different ETFs on the market currently, including "Cubes" (Nasdaq-100 Trust), SPDRs, sector SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds. All of them are passively managed, tracking a wide variety of sector-specific, country-specific, and broad-market indexes.
How do ETFs work?
ETFs are hybrid securities that combine the diversification advantage of mutual funds with the trading flexibility of stocks. They are traded on an exchange throughout the day. Unlike regular mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. The forces of supply and demand for the ETF shares can impact their prices and potentially drive them away from the value of the underlying basket of stocks. However, this opens up the possibility for arbitrage opportunities, which would force the ETF prices back in line. In other words, there are some mechanisms in place that should help prevent sustained discounts or premiums from opening up.
How can I buy or sell ETFs?
Investors can buy or sell ETFs through a broker, the same as stocks.
How easily can I buy or sell ETFs?
As easily as buying or selling shares of stock. ETFs are listed on an exchange and can be traded intraday, making it easy for investors to buy or sell.
What are the benefits of ETFs trading as stocks?
The unique "exchange traded" structure offers several advantages to ETF investors:
- buy and sell at any time during the trading day
- have instant exposure to a portfolio of stocks or bonds
- buy on margin
- sell short, even on a downtick
- lower fees
- tax efficiencies
Can ETFs be purchased on margin?
Exchange-traded funds may be purchased on margin, subject to the same terms that apply to common stocks. Investors should contact their broker regarding initial and maintenance margin requirements.
Can ETFs be sold short?
Yes. All ETFs may be sold short, representing the sale of "borrowed" shares in anticipation of lower prices. ETFs are exempt from the rule that requires shares to be sold short on a plus or zero plus tick.
What are the structural differences between ETFs and mutual funds?
While ETFs are registered with the Securities and Exchange Commission as investment companies - either as an open-end fund or a unit investment trust - they differ from traditional mutual funds both in how their shares are issued and redeemed and in how their shares or units are traded. Unlike traditional mutual funds or unit investment trusts, ETF shares are created by an institutional investor depositing a specified block of securities. In return for this deposit, the institutional investor receives a fixed amount of ETF shares, some or all of which may then be sold on a stock exchange. The institutional investor may obtain its deposited securities by redeeming the same number of ETF shares it received from the ETF. Retail investors can buy and sell the ETF shares once they are listed on an exchange.
What are ETF assets relative to mutual fund assets?
By the end of 2003, overall ETF assets totaled $154.8 billion, compared to $7.6 trillion in mutual funds.
How many ETFs are available to investors?
As of December 2003, 124 exchange-traded funds were available to investors, versus 91 funds at the end of 2000.
How long have ETFs been available to investors?
The first exchange-traded fund, an S&P 500 Index fund, began trading on the American Stock Exchange in January 1993. A second ETF tracking the S&P MidCap 400 Index was added in 1995 and 17 ETFs linked to international stock exchanges began trading in 1996.
Do ETFs track international indexes?
Yes. As of December 2003, 41 ETFs tracked global/international stock indexes. Most of the global/international ETFs are either country-specific or regional index funds. However, a few ETFs track global index funds. By December 2003, global/international ETFs held $13.98 billion in assets.
How are ETFs regulated?
Exchange-traded funds are registered investment companies and must comply with the applicable provisions of the Investment Company Act, except to the extent the fund or trust has received exemptive relief from the Act. Exchange-traded funds have obtained exemptive relief to
(1) allow them to register as mutual funds under the Act even though their shares are not individually redeemable (ETFs are, however, prohibited from referring to themselves as mutual funds);
(2) permit affiliated entities to purchase and redeem shares in kind rather than in cash;
(3) enable their shares to trade at negotiated prices on an exchange rather than at a current offering price described in the prospectus or at a price based on net asset value (NAV).
How does the performance of an ETF compare with the performance of its underlying index?
Exchange-traded funds are designed to provide investment results that generally correspond to their underlying benchmark index by holding a portfolio of securities designed to give similar price and yield performance. In the secondary market, one mechanism that helps to keep an ETF trading on the exchange at a price close to the value of its underlying portfolio is arbitrage. Because ETFs are both created from the securities of an underlying portfolio and can be redeemed into the securities of an underlying portfolio on any day, arbitrage traders may move to profit from any price discrepancies between a fund and the portfolio. This in turn helps to close the price gap between the two. (ETF creations and redemptions are restricted to large transactions, typically in multiples of 50,000 shares but ranging from 25,000 to 600,000 shares, usually transacted by large investors and institutions.) Of course, because of the forces of supply and demand and other market factors, there may be times when shares of an ETF trade at a premium or discount to its underlying portfolio value.
Where do ETFs initially come from?
Exchange traded funds are "created" by large investors and institutions in block-sized units of shares (or multiples thereof) known as "Creation Units" of a respective ETF. A creation requires a deposit with the trustee for a specified number of shares of a portfolio of securities closely approximating the composition of the specific index and a specific amount of cash in return for shares of a specific exchange traded fund. Similarly, block-sized units of ETF shares can be redeemed in return for a portfolio of securities approximating the index and a specified amount of cash.
Where can I find ETFs listed in the newspaper?
Investors can find ETFs listed in the financial section of many newspapers under the heading "American Stock Exchange Listed Stocks." They are also listed under "Exchange Traded Portfolios" in the financial section of The Wall Street Journal.
Is the value of an ETF equivalent to the value of the underlying index?
Not necessarily. The share price of many exchange-traded funds is initially set at a percentage of the index upon which they are based, but may differ over time due to costs and other factors.
What are the risks of investing in ETFs?
Equity-based exchange traded funds are subject to risks similar to those of stocks, while fixed-income-based ETFs are subject to risks similar to those of bonds. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Past performance is no guarantee of future results.
Do I get paid dividends on ETFs?
ETF holders are eligible to receive their pro-rata share of dividends, if any, accumulated on the stocks held in an ETF, and interest on the bonds held in an ETF, less fees and expenses. Of course, based on past performance, little, if any, dividend distributions can be expected on certain ETFs. There may also be the opportunity for dividend reinvestment.
Are there different tax implications for investors in gold ETFs versus other ETFs?
Yes. Investor gains realized from gold ETFs are taxed as if that investor owns the underlying gold. This means that taxes are levied at a higher rate than capital gains. While the tax rate on the majority of long-term capital gains rests at 15 percent, gains recorded on the sale of "collectibles" (such as gold bullion) held for a period of greater than one year face a maximum tax rate of 28 percent.
